While I blogged
about the potential regulation of the UK equity
market by the SEC nearly two weeks ago, it took the collapse of Amaranth
to draw my attention to the fact that a growing part of the US
energy derivatives market is now regulated by the UK.

In January 2006, the Intercontinental Exchange (ICE) was permitted to
use its trading terminals in
the United States for the trading of US (WTI) crude oil futures on
ICE Futures in London (formerly the International Petroleum Exchange
or IPE). This was not a totally new contract because ICE simply took its
electronically traded, standardized OTC contracts and offered them on
ICE Futures. Therefore, these contracts
have seen high initial adoption and rapid growth in the last few
months. WTI volumes in ICE Futures are now about half
of the NYMEX volumes. We now have a liquid contract on a US commodity that is
predominantly traded by US participants using terminals in the US, but
the contract is on an exchange (ICE Futures) which is located and
regulated in the UK, though it is owned by a US entity (ICE).

More interesting is the fact that ICE also runs a large quasi
futures market in energy derivatives. These are OTC contracts for
regulatory purposes but are standardized, electronically traded and
cleared through London’s LCH. LCH is UK regulated, but it is
also a Designated Clearing Organization in the US. Amaranth served to
remind us that when it comes to natural gas “futures”, ICE is
today larger than NYMEX.

Even before Amaranth, the US political system was worried about
this just as the UK is worried about potential regulation of UK
equities by the US. The US Senate has prepared a report
arguing for greater US (CFTC) regulation of the derivatives traded at
ICE (“The role of market speculation in rising oil and gas
prices: A need to put the cop back on the beat”, Staff Report
prepared by the Permanent Subcommittee on Investigations of the
Committee on Homeland Security and Governmental Affairs, United States
Senate, June 2006).

Incidentally, this week the US SEC met with Euronext regulators
about the potential acquisition of Euronext by NYSE. The SEC’s
press
release states: “The regulators also affirmed that joint
ownership or affiliation of markets alone would not lead to regulation
from one jurisdiction becoming applicable in the other and stated
their shared belief in the importance of local regulation of local
markets.” That sounds categorical until one reads it again more
carefully and realizes that it means nothing at all. Today there are
no purely local markets. US investors do trade UK stocks at the LSE
and the LSE is no longer a purely local market. All bets are then
off.

The UK has in the last week been involved in two tussles about extra
territoriality but has been on opposite sides in the two tussles. In
the case of the possible acquisition of the London Stock Exchange
(LSE) by Nasdaq, the UK has been eager to ensure that the
extra-territorial jurisdiction of US law (particularly Sarbanes Oxley)
does not affect companies listed at LSE. In the case of Cadbury
Schweppes, it is the UK that has been told to stop exerting
territorial jurisdiction to impose a tax on the UK company’s
Dublin subsidiary which is subject to low taxes there.

The fear of extra-territorial jurisdiction of US laws over a US
owned LSE is quite well grounded. Way back in 1979, in the wake of the US
hostage crisis, President Carter issued Executive
Order 12710 under the International Emergency Economic Powers Act
stating: “I hereby order blocked all property and interests in
property of the Government of Iran, its instrumentalities and
controlled entities and the Central Bank of Iran which are or become
subject to the jurisdiction of the United States or which are in or
come within the possession or control of persons subject to the
jurisdiction of the United States.” Nearly half of the blocked
money was in deposits outside the US (principally in London). While
the Iranians did sue in London to release these funds, the courts and
governments were slow in resisting the extra-territorial demands of
the US order and since the entire hostage crisis lasted only 14
months, the legality of the US freeze was not adequately tested. A
good account of this episode is provided by Robert Carswell’s
article “Economic sanctions and the Iran experience”,
in Foreign Affairs, Winter 1981/1982.

In later sanctions against other countries, the US was less
successful. For example, “a U.S. bank in the United Kingdom was
ordered by a British court to release a Libyan bank’s assets
blocked under U.S. unilateral sanctions in 1986. The United States
subsequently authorized the release of the assets.” (GAO-04-1006
“Foreign Regimes’ Assets: The United States Faces
Challenges in Recovering Assets, but Has Mechanisms That Could Guide
Future Efforts”, Government Accountability Office, 2004)

Extra-territorial reach over UK listed companies through a change
in exchange regulations would be less vulnerable to judicial
challenge. The UK government therefore wishes to have a statutory
weapon against it. In a speech on September 13, 2006, Economic Secretary to the Treasury,
Ed Balls stated “ the UK Government will now legislate to
protect our regulatory approach. This legislation will confer a new
and specific power on the FSA to veto rule changes proposed by
exchanges that would be disproportionate in their impact on the
pivotal economic role that exchanges play in the UK and EU economies.
It will outlaw the imposition of any rules that might endanger the
light touch, risk based regulatory regime that underpins London's
success.”

The Financial Services Authority has made its view clear in
February 2005 and again in June 2006.

[W]e will be indifferent to the nationality of the owners or the
managers of any future combined operation, and will be concerned to
ensure that the future operation meets our regulatory standards. If
the LSE remains a UK exchange under a new parent it will continue to
be subject to FSA regulation as a Recognised Investment Exchange
(RIE).

The LSE, as a UK RIE, plays a key role as a focal point for the wider
regulatory framework, including capital raising and corporate
governance. The attractiveness of the UK financial markets, and
ultimately the competitiveness of EU capital markets, depends, in
part, on a system of corporate governance and of regulation which is
of a high standard, but is proportionate and adaptable and attuned to
the requirements of users. (“Potential longer term implications of a
change of ownership of the London Stock exchange”,
FSA/PN/015/2005,
4 February 2005)

However, we believe that there could be circumstances where a more
complex regulatory position might arise. Theoretically, in the longer
term, a new entity might seek to achieve further benefits from
rationalisation of its regulatory structure. This could at the extreme
involve the LSE no longer being subject to UK regulation as an
RIE. Its services might be provided from outside the UK, either from
the US, another EU member state or an alternative location, through
the provision of trading screens in the UK and with securities
admitted to trading on the market operated from elsewhere. Such a
move, were it to occur, would potentially have significant
implications for various aspects of the wider regulatory regime as
indicated in our February 2005 statement. If such a market were to be
operated from the US it would require member firms and issuers to be
registered with the SEC and subject to its
oversight. (“Implications of ownership of a UK Recognised
Investment Exchange by a US entity”, FSA/PN/055/2006
12th June 2006).

It is ironic therefore that the UK had to be reminded this week
about the extra-territoriality of its own tax laws by the European
Court of Justice. Though the tax rate in Dublin’s International
Financial Services Centre is only 10%, the UK claimed an additional
20% tax on the Dublin subsidiaries of Cadbury Schweppes on the ground
that these were “controlled foreign companies”. The
European Court ruled that if the foreign subsidiary has offices, staff
and operations in the foreign country, then the fact that it was set
up with an intention to obtain tax relief does not make it a wholly
artificial arrangement that justifies levying UK tax rates. Ireland is
a country that has built up a vibrant financial services industry on
the strength of a sound regulatory and tax regime. The court ruling
will hopefully allow this to survive.

In general, I like regulatory competition. I think of a regulator
as being in the business of manufacturing and providing regulatory
products and services. Consumers of these products and services
(investors, issuers and others) benefit if this
industry is competitive. Similarly, healthy competition in tax rates
also helps put a bound on the rapacity of the nation
state. A vigorous defence of the competitive structure of the
market for regulatory services is therefore very much welcome.

Buried inside the Global
Financial Stability Report of the IMF
(September 2006) is a graph showing India and New Zealand as the
outliers in terms of high financial leverage in the household sector,
but the data does not seem right. Figure 2.10 on page 55 shows Indian
household leverage (ratio of financial liabilities to financial
assets) as about 60%, exceeded only by New Zealand’s 80%. India
does not publish sectoral balance sheets, but the flow of funds data
is grossly at variance with this number of 60%. If we cumulate the
last several years’ change in financial assets, liabilities and
physical assets from Tables 10 and 11 of the RBI’s Handbook of
Statistics, 2005, the following picture emerges. Cumulative household
financial savings are about 100% of GDP, cumulative household
financial liabilities are about 20% of GDP and cumulative household
physical savings are about 80% of GDP. This would imply household
leverage of 20/180 or about 11%. This broad picture does not change
whether I cumulate the last 35 years of data or just the last 10. I am
struggling to understand how the IMF gets a number more than 5 times
this estimate of about 11%. If one considers that most household
assets (equities, real estate or gold) would have appreciated in value
over the years while most liabilities would be fixed in nominal terms,
the financial leverage evaluated at market prices must be even lower
than the above estimate of 11%. Of course, the IMF says that it got
the number from national authorities. So does the RBI/MOF/CSO see some
household leverage out there that we are not seeing? Or is it all a
mistake?

While corporate disclosure in offer documents and to a lesser
extent in annual reports is reasonably informative and neutral,
material event disclosure still tends to consist of sanitized half
truths. I have spent some time comparing:

the Form
8-K filed with the US SEC by the Hewlett Packard Company on
September 6, 2006 about its investigation of board room leaks,
and

the news report (“Leak, Inquiry and Resignation Rock a
Boardroom” by Damon Darlin) about the same event in the
New York Times of September 7, 2006

The New York Times reports that Thomas Perkins resigned
from the HP Board in protest when he found that HP had used private
detectives to monitor telephone calls by board members. It also
reports that these detectives approached the phone company with the
last four digits of Perkins’ social security number and tricked
them into “revealing the multidigit code that would allow a
person to set up an online account for access to billing statements
”. Using this the detectives viewed the list of his phone
calls. According to the news report, Perkins regards this as
“possible fraud, identity theft and misappropriation of personal
records”

The same events are described in HP’s SEC filing as follows:
“the Chairman of the Board, and ultimately an internal group
within HP, working with a licensed outside firm specializing in
investigations, conducted investigations into possible sources of the
leaks of confidential information at HP. ... some form of
‘pretexting’ for phone record information, a technique used by
investigators to obtain information by disguising their identity, had
been used. ... The Committee was then
advised by the Committee’s outside counsel that the use of pretexting
at the time of the investigation was not generally unlawful (except
with respect to financial institutions), but such counsel could not
confirm that the techniques employed by the outside consulting firm
and the party retained by that firm complied in all respects with
applicable law.”

The SEC filing also asserts that the “Date of Earliest Event
Reported” in the filing is August 31, 2006. Since the
“pretexting” in question happened in May 2006 or earlier
and had not previously been disclosed by HP, it would appear
that this statement at least is false. Probably, HP wants to avoid an
impression that it was tardy in filing the Form 8-K. Or perhaps, HP
wants to claim that what is being disclosed is not all the sordid mess
about the undercover investigation, but that as a result of
the investigations, the Board decided on August 31, 2006 not to
renominate George Keyworth who was reportedly the source of the
leaks.

The Form 8-K filed by HP appears to me to be excessively sanitized
to the extent of failing to communicate the gravity of the
events. For example, “disguising their identity” is quite
different from impersonating somebody else. It is evident that
material event disclosure has a long way to go
even in the US. In countries like India, the state of affairs is much
worse.

I think we should move towards capital account convertibility much
faster and much more boldly than the CAC 2.0 report suggests. A freely
convertible currency by 2010 should be the goal.

I believe that it is impossible to ban Participatory Notes (PNs)
when portfolio investment is opened up to non institutional
investors. This is because:

The PN is traded between foreigners outside India

If neither party to the PN is an FII, then the PN does not involve
any party who is regulated by or registered with an Indian
regulator. Compliance with a KYC norm is not the same as acceptance of
regulatory jurisdiction.

The PN is a cash settled OTC derivative that does not require any
money or securities to change hands in India.

Even if for a moment one can think up a legal theory that creates
jurisdiction, it is infeasible to exercise such jurisdiction. It is
one thing to threaten to prosecute 500 FIIs. It is another thing to do
that with 50,000 non institutional investors who do not even have a
home country regulator.

In an FII oriented regime where only a select few can invest
in India, the regulation of PNs serves to prevent others from getting
a back door entry. In the proposed regime where any body can come in
through the
front door, I do not understand why the government should go to great
lengths to
prevent anybody trying the back door. The whole debate about PNs makes
sense only if the FII regime continues. The moment that is diluted,
the case against PNs vanishes.

The Reserve Bank of India (RBI) has published the report
of the Committee on Fuller Capital Account Convertibility chaired by
S. S. Tarapore. A
committee with the same chairman and almost the
same set of members gave a report on Capital Account Convertibility to
the RBI in 1998. Therefore, in line with phrases like Web 2.0 and
Bretton Woods 2.0, I have chosen to call it CAC 2.0.

I resolved not to blog about CAC 2.0 until I had read the report
fully. Since the report is over 200 pages long, it was only with great
difficulty that I have managed to adhere to this resolve. My first set
of comments are as follows:

The dissent notes by Surjit Bhalla and A. V. Rajwade are more
interesting and thought provoking than the main report itself.

CAC 1.0 at 80 pages was less than half the length of CAC 2.0. It was also
characterized by much greater conceptual clarity and internal
consistency. In fact, CAC 1.0 could be summarized in two sentences:
“Based on an assessment of macro economic conditions, the
Committee is of the considered view that the time is now apposite to
initiate a move towards CAC. ... Fiscal consolidation, a mandated
inflation target and strengthening of the financial system
should be regarded as crucial preconditions/signposts for CAC in
India.” Everything in CAC 1.0 reflected this philosophy and
while I disagreed with CAC 1.0 for being too cautious, I could not
fault its internal consistency. One would struggle to find a similar
succint philosophy for CAC 2.0

CAC 1.0 took place in the backdrop of the Asian crisis. CAC 2.0
takes place in the backdrop of a much stronger external position and
greater optimism about India. Yet a high degree of timidity permeates
CAC 2.0.

The most controversial recommendation of CAC 2.0 is about
Participatory Notes (PNs). A PN is a cash settled OTC derivative sold
by a registered foreign institutional investor (FII) to entities outside
India. Though these instruments are traded between foreigners outside
India, Indian regulators have exercised jurisdiction over them relying
on the fact that the FII which issues these PNs is registered with
Indian regulators. CAC 2.0 recommends a complete ban on new PNs and
the liquidation of existing PNs within one year. The argument given is
that “In the case of Participatory Notes (PNs), the nature of
the beneficial ownership or the identity is not known unlike in the
case of FIIs”. In the same breath,
CAC 2.0 recommends that foreign corporate and individual investors
should be allowed to invest in India through entities registered with
the Indian regulators. On the face of it, therefore, a US hedge fund would be
able to invest in India through an Indian stock broker who would be
responsible for enforcing the Know Your Client norms. Or perhaps,
the hedge fund would come through an Indian portfolio manager
offering a non discretionary portfolio management service. In either
case, the foreign entity is not now registered with the Indian
regulator and not subject to its jurisdiction. How the Indian
regulator would now enforce a ban on that unregulated entity selling
cash settled OTC derivatives outside India is beyond my
comprehension. Finally, if any foreign entity can invest in India
directly, it is difficult to see what is gained by banning PNs. A
foreign investor can easily hide behind several layers of special
purpose vehicles and corporate entities that make it impossible to
determine beneficial ownership even if all Know Your Client norms are
adhered to. The recommendations lack internal consistency.